(Corrects spelling of Indian minister's name to Antony from Anthony in fifth para of Jan. 1 story)

* India says terminates $770 mln contract immediately

* New Delhi appoints former judge as its arbitrator

* AugustaWestland parent Finmeccanica says to defend position

* Finmeccanica says its "behaviour was ethically correct"

By Nigam Prusty and Krishna N Das

NEW DELHI, Jan 1 (Reuters) - India cancelled its $770 million helicopter deal with Italian defence group Finmeccanica's AgustaWestland unit on Wednesday over what it termed a breach of integrity, but agreed to take part in an arbitration process.

India froze payments for the 12 AW101 helicopters after Finmeccanica's then chief executive was arrested in February for allegedly paying bribes to secure the deal, embarrassing the New Delhi government before parliamentary elections due by May 2014.

The scrapping of the deal, which will now go through a probably lengthy legal process, would be a fresh setback for Finmeccanica. Delays in selling some of its money-losing assets have prompted credit rating agencies to downgrade the company to junk.

But it would offer an opportunity for rivals such as United Technologies Corp's Sikorsky Aircraft, EADS unit Eurocopter and Lockheed Martin to get a share of India's burgeoning defence market.

India's defence minister, A.K. Antony, has said he did not believe AgustaWestland's denial that it paid bribes to swing the deal. Antony had a meeting with Indian Prime Minister Manmohan Singh hours before the latest decisions were announced.

"The Government of India has terminated with immediate effect the agreement that was signed with M/S. AugustaWestland International Ltd (AWIL) on 08 February, 2010 for the supply of 12 VVIP/VIP helicopters on grounds of breach of the Pre-contract Integrity Pact and the agreement by AWIL," the Defence Ministry said in a statement on Wednesday.

Finmeccanica spokesman Roberto Alatri, commenting on India's decision, said the company would defend its position. It invoked the arbitration, which would be conducted in India under the Indian Arbitration and Conciliation Act of 1996.

"We'll do everything that would be necessary to defend the correctness of our position," Alatri told Reuters. "We're sure our behaviour was ethically correct."

He said India's agreement to arbitration was a positive step.

India's Defence Ministry said it believed "integrity-related issues are not subject to arbitration" but nominated an arbitrator, it said, to safeguard its interests.

Uday Bhaskar, a defence analyst at the Society for Policy Studies in New Delhi, said India's participation in the arbitration did not represent a climb-down.

"Cancelling deals and saying that we will not acquire critically-needed equipment, to my mind, is not the answer," Bhaskar said.

"But there's no climb-down on this arbitration and as a matter of fact it might be the most viable via media (middle road)."

India in October had issued a final "show cause" notice to AgustaWestland seeking to terminate the contract. Sources told Reuters in November the deal would be scrapped.

ALLEGATIONS

Indian defence deals have been hit by a number of corruption allegations over the past two decades but a Defence Ministry spokesman said this was the first cancellation of a major deal.

Paying or accepting bribes is prohibited by India's defence procurement rules. The government can cancel a contract if an integrity pact in the rules is violated, and the seller has to forfeit any security money it deposited as a bidder.

India's federal auditor said in August the ministry had initially stipulated that the helicopters should be able to fly to an altitude of 6,000 metres (19,685 feet), which meant that AgustaWestland could not compete since the AW101 was certified to fly only to 4,572 metres (15,000 feet).

India took delivery of three of the helicopters before the deal stalled but the Defence Ministry spokesman said the fate of those aircraft was "uncertain".

(Additional reporting by Sankalp Phartiyal in Delhi and Steve Scherer in Rome; Editing by Louise Ireland and Anthony Barker)